Thursday, June 30, 2011

Excerpt: Greek Prime Minister George Papandreou clinched enough votes to pass the first part of an austerity plan aimed at meeting European Union aid requirements and staving off default for his debt-laden nation.

Having gained enough votes in the 300-seat Parliament, Papandreou is now on track to secure a bill setting out the strategy for a 78 billion-euro ($112 billion) package of budget cuts and asset sales that is the condition for further rescue funds...

“The overriding feeling across Europe will be relief,” Tobias Blattner, an economist at Daiwa Capital Markets Europe in London and a former European Central Bank official, said before the vote. “There will always be people who say it won’t really change anything and we’ll still get a haircut, but at least it will buy time and calm the markets....

State Assets
Apart from sales of state assets such as a stake in Public Power Corp SA (PPC), the former power monopoly and levies ranging from 1 percent to 5 percent on wages, Papandreou’s plan includes higher taxes on restaurants and bars, higher heating-oil taxes and lowering the tax-free threshold to 8,000 euros from 12,000 euros presently. Greek newspaper To Vima calculated the additional burden for an average Greek family of four at 2,795 euros a year, about the same as one month’s income.

Implementing more austerity measures threatens to deepen a three-year recession and complicate efforts to boost government revenue. Greek gross domestic product, which contracted 4.4 percent in 2010, will shrink a further 3.8 percent this year, according to a report from EU and IMF inspectors in June. The nation’s debt load will peak at 166 percent of GDP next year, and is already the biggest in the euro-region’s history.

Excerpt: China is hoping to cool its white- hot economy without precipitating a recession. Doing so will be extremely difficult: Inflation fears are growing, the government’s ability to respond is quite limited, and China’s economic model, which leaves bureaucrats guessing about the market effects of their directives, is ultimately untenable....

The government is fearful of rising prices, and has moved to prevent speculation. Buyers must now put down 60 percent of the purchase price on second homes, and 30 percent on first homes. The government is pressing banks to contain mortgages, and some have raised interest rates. In January, the mayor of Shanghai announced a new tax on property transactions that may be copied nationwide as other officials attempt to cool prices.

With these restraints in place, and with supply starting to catch up with demand, housing sales have slowed. But this has not fully curtailed China’s real-estate bubble: Housing starts rose about 40 percent last year. Developers are rushing to build while they try to support faltering prices by delaying completions and creating artificial shortages. Of course, these efforts are difficult to maintain because they tie up capital in uncompleted houses. Houses are now being built at about twice the rate they’re being sold, well above earlier norms...

Prices Rising

Housing isn’t the only area where signs of inflation are popping up. In May, consumer prices increased 5.5 percent versus a year earlier. In December, Chinese leaders agreed to “put stabilizing the overall price level in a more prominent position” in their ranking of economic priorities. In a country where many live at or below the poverty level, food costs are obviously a major concern, and they jumped 11.7 percent in May from a year earlier....

I suspect that such a hybrid market system is too unwieldy to allow the Chinese government to manage a soft landing for its economy. By my reckoning, the Federal Reserve has tried 12 times in the post-World War II era to cool an overheating economy without precipitating a recession. It succeeded only once. Can the politically controlled Chinese central bank, and the government leaders who really call the shots, be more successful than the independent Fed?
That seems unlikely. And the consequences, for China and the world economy, could be unfortunate.

BEIJING - Local governments had an overall debt of 10.7 trillion yuan ($1.65 trillion) by the end of 2010, said China's top auditor on Monday in a report to the National People's Congress.

He warned that some were at risk of defaulting on payments.

It was the first time the world's second-largest economy publicly announced the size of its local governments' debts. The scale amounts to more than one-quarter of its GDP in 2010, which stood at 39.8 trillion yuan.

Liu Jiayi, head of the National Audit Office (NAO), said local governments at county, city and provincial level all have outstanding debts, with the exception of 54 county-level governments.

Excerpt: Pacific Investment Management Co. LLC Chief Executive Officer Mohamed El-Erian said a short-term default by the U.S. on its debt might have “catastrophic” legal consequences.

“We would be in the land of the unpredictable” if lawmakers fail to reach an agreement to raise the $14.3 trillion debt ceiling and the U.S. misses a payment “simply because of the technical linkages,” El-Erian said in an interview on CNN’s “Fareed Zakaria GPS” program, scheduled to air today.

U.S. lawmakers are seeking a path to increasing the debt limit and to cutting at least $1 trillion from the long-term deficit before an Aug. 2 deadline. President Barack Obama plans to hold separate meetings at the White House June 27 with Senate leaders Nevada Democrat Harry Reid and Kentucky Republican Mitch McConnell in an effort to break an impasse that scuttled a seven-week negotiating effort led by Vice President Joe Biden.

“My advice is please try and get together and solve this issue in the context of a medium-term reform package,” El-Erian said. “If you can’t do that and you’re going to kick the can down the road, kick the can rather than face something that could be catastrophic in terms of legal contracts being triggered.”...

“A basic rule as an investor is don’t buy something unless you know who else is going to be buying,” he said. “So when we look at Treasuries, we see the big buyer stepping away from the market, for certain. And we ask the question, who else is going to be buying at these levels, and we can’t identify another buyer of the size of the Fed.”

Excerpt: — President Barack Obama is in a fragile position as the 2012 campaign begins: Only 37 percent of registered voters approve of his handling of the economy, his lowest rating ever, according to a new McClatchy-Marist poll.

Another ominous sign for Obama: By nearly 2-1, voters disapprove of how he's handling the federal budget deficit, expected to hit a record $1.5 trillion this fiscal year, which ends Sept. 30.

Excerpt: Home prices decreased in the year ended April by the most in 17 months, showing the housing market remains an obstacle for the U.S. recovery.

The S&P/Case-Shiller index of property values in 20 cities fell 4 percent from April 2010, the biggest drop since November 2009, the group said today in New York. From March to April, prices fell 0.1 percent on a seasonally adjusted basis, the smallest decline since July 2010.

A backlog of foreclosures and falling sales raise the risk that prices will decline further, discouraging builders from taking on new projects. The drop in property values and a jobless rate hovering around 9 percent are holding back consumer sentiment and spending, which accounts for 70 percent of the economy....

Shiller told a conference in New York this month that a further decline in property values of 10 percent to 25 percent in the next five years “wouldn’t surprise me at all.”
The Case-Shiller gauge is based on a three-month average, which means the April data was influenced by transactions in March and February.

“There’s no sign of any real recovery in housing yet,” Jim O’Sullivan, chief economist at MF Global Inc. in New York, said before the report. “There won’t be a significant turn until the labor market shows sustained improvement. The level of foreclosures is still high and a lot of people are delinquent on their mortgages.”

Excerpt: When Timothy Geithner, US Treasury secretary, recently spoke with senior bankers at a conference in Atlanta, for example, he pointed out that the shadow banking world had been cut in half since 2007.

But on Wall Street, at least, there is little sense right now that the shadow banking sector is in decline: on the contrary, as rules on the banks tighten, activity and personnel are shifting into the shadow world at an accelerating rate. Or as the head of one Wall Street private equity group says, “We are heading towards the golden age of [non-bank] finance companies ... and that is largely because of what regulators are doing with the banks.”

Annaly is a case in point. The group was founded just over a decade ago, originally as a mid-sized real estate investment trust. However, in the past three years – or since the financial crisis erupted – its assets have grown to more than $110bn, comparable to that of America’s small banks. That is partly because the REIT business has boomed, as the securitisation market has suffered in the past three years. However, Annaly has also started moving into sectors which used to be dominated by banks, partly because it can often operate more profitably in some areas because as a non-bank it is regulated by the Securities and Exchange Commission – and thus does not need to meet banking rules on, say, capital adequacy.

Thus Annaly is gobbling up loans being shed by the large banks. It is also providing finance to mortgage companies. Next it hopes to start purchasing the assets currently held by state entities, when these are sold in the coming years. And it is far from alone: a host of Annaly-style funds are now also applying for licences with the SEC, to pursue similar activities. The private equity group TPG is now moving into the business of middle-tier corporate lending. And Fortress, another large private equity firm cum hedge fund, is chasing similar opportunities, along with some hedge funds.

This trend leaves some observers fretting about new systemic risks. “It is crazy what is going on – business is being pushed out of the regulated banks into parts of the system that regulators cannot see,” complains one of Wall Street’s most senior lawyers. But Annaly, for its part, denies this: they argue that because they are answerable to hands-on investors, rather than distant regulators, it makes them more – not less – prudent in managing credit risk.

It is impossible right now to tell whether this is true; the real test may not come for several years. But the one thing that is clear is that this trend is unlikely to end anytime soon. Investors and regulators had better hope, in other words, that this new breed of shadow banks does turn out to be better run than before. If not, historians may yet view this period as (yet another) lesson in the unintended consequences of regulatory reform.

Excerpt: With 6 of the past 7 weeks in the red, the markets have managed to string together a series of winning days. Daily gains both this week and last have ranged between 0.50% and 1.25%. Indeed, the Dow’s gains on Monday and Tuesday represent the first consecutive triple digit gain for the Industrials since December 1- 2, 2010. This was the fourth triple digit rally since the April 29th highs.

Are we making a major turn? Has psychology become so bad its a contrary indicator? Has the 200 day moving average proved to be inviolable?

Perhaps any of those explanations might prove to be the case, although I have my suspicions otherwise. I suspect it is simply a case of funds marking up stocks into the close of the 2nd quarter.

What data supports this thesis? I would point to 2 things: Psychology and Trading Volume. Most metrics are showing psychology is either neutral or optimistic. This tends to be supportive of a short term trading bounce, and not a longer-lasting rally.

Second, the volume has been anemic, even by the unusually low levels we have seen all year. The overall volume on Monday was well below the 30-day average on both NYSE and Nasdaq. Tuesday was even lower. Rallies on increasingly lighter volume are not signs of aggressive institutional buying. Rather, it supports the Window dressing thesis.

Excerpt: Forget Prozac. Only jobs and bigger paychecks will cure these blues.

The Conference Board said Tuesday its confidence index fell to 58.5 in June, the lowest reading since November 2010. Assessments of both present economy and the future fell. The big trigger for the blues: Increased worries about jobs and future paychecks.

The report showed a deteriorating view of the labor markets both now and six months down the road. And the percentage of consumers who think their income will decrease six months from now rose to 16.5%, the highest rate since August 2010.

These doubts about the future are likely to translate into weaker spending if better data don’t change consumer attitudes. “Given the combination of uneasiness about the economic outlook and future earnings, consumers are likely to continue weighing their spending decisions quite carefully,” said Lynn Franco, director of the board’s Consumer Research Center.

Bear in mind that real consumer spending in the second quarter is on track to increase by the slowest rate since possibly the fourth quarter of 2009. Continued shopping caution will be a problem for second-half growth.

Of course, it’s not just jobs weighing down consumers — although labor prospects are always paramount. The squeeze on budgets and shrinking wealth are also preventing consumers from believing their economic situation is getting better even though the U.S. recovery is now two years old.

According to the S&P/Case-Shiller report released Tuesday, the April composite index of home prices in 20 major cities has plunged 32.8% from its mid-2006 peak. That means homeowners in general are one-third poorer than they were five years ago.

Excerpt: White House spokesman Jay Carney said after the meeting with Reid that “everybody believes a significant deal remains possible.” He added that Obama and the Democrats are pushing for a “balanced approach” to an agreement tied to the raising of the US debt ceiling. The US Treasury has said that the government will be unable to pay its bills after August 2 if the ceiling is not raised.

By “balanced” it is meant a deal that contains some token gestures—either the elimination of a few select corporate tax loopholes or minimal cuts in defense spending—that will give Democratic legislators political cover to vote for what all sides agree must involve major cuts in social spending....

Obama’s role will be to shift the balance of the discussion further to the right. The Democrats have already made clear that they won’t push for any increase in actual tax rates for the wealthy. The few corporate tax loopholes they are proposing to end are more than offset by the business tax reductions proposed by Obama as part of his “jobs program.”...

According to the AP, the deal would also require federal workers to pay more into their pensions. “Democrats are wary and won’t allow the $120 billion-plus sought by Republicans over the coming decade, but appear to be likely to accede to some of the savings.”

Wednesday, June 29, 2011

Excerpt: Productivity has surged, but income and wages have stagnated for most Americans. If the median household income had kept pace with the economy since 1970, it would now be nearly $92,000, not $50,000.....(great charts)

Excerpt: China is much more vulnerable to an international slowdown than is generally understood. In late 2007, my firm’s research found that too few people in China had the discretionary spending capability to support its economy domestically. Our analysis showed that it took a per-capita gross domestic product of about $5,000 to have meaningful discretionary spending power in China.

About 110 million Chinese had that much or more, but they constituted only 8 percent of the population and accounted for just 35 percent of GDP in 2009, while exports accounted for 27 percent. Even China’s middle and upper classes had only 6 percent of Americans’ purchasing power.

Why Overconfidence Abounds

With such limited domestic spending, why do so many analysts predict that China can continue its robust growth?

In part because they believe in the misguided concept of global decoupling -- the idea that even if the U.S. economy suffers a setback, the rest of the world, especially developing countries such as China and India, will continue to flourish. Recently -- after China’s huge $586 billion stimulus program in 2009; massive imports of industrial materials such as iron ore and copper; booms in construction of cement, steel and power plants, and other industrial capacity; and a pickup in economic growth -- the decoupling argument has been back in vogue.

This concept is flawed for a simple reason: Almost all developing countries depend on exports for growth, a point underscored by their persistent trade surpluses and the huge size of Asian exports relative to GDP. Further, the majority of exports by Asian countries go directly or indirectly to the U.S. We saw the effects of this starting in 2008: As U.S. consumers retrenched and global recession reigned, China and most other developing Asian countries suffered keenly....

Overconfidence in China’s ability to keep its economy booming is also partly psychological. It reminds me of the admiration and envy (even fear) that many felt toward Japan during its bubble days in the 1980s. As Japanese companies bought California’s Pebble Beach, Iowa farmland and Rockefeller Center in New York, what was safe from their zillions? Then the Japanese stock and real-estate bubbles collapsed, and Japan entered the deflationary depression in which it’s still mired....

They were enjoying a well-oiled growth machine. Growing exports, especially to American consumers, stimulated the capital spending needed to produce yet more exports and jobs for the millions of Chinese streaming from farms to cities. Wages remained low, due to ample labor supplies, and held down consumer spending. So did the high Chinese consumer saving rate. Because Chinese could not invest offshore, much of that saving went into state banks at low interest rates. The money was then lent to the many inefficient government-owned enterprises at subsidized rates.

In a country where stability is almost worshipped, why would any leader want to disrupt such a smoothly running economy?

Jim Hamilton analyzes the effects of the International Energy Agency's plans to release 60 million barrels of oil from the strategic reserves held by 28 member countries (the US will contribute about half of this total). I think it would be fair to say he's not impressed with this plan:

The Strategic Petroleum Reserve drawdown, econbrowser

I share his assessment:

...the deed is now done, and the IEA has run an interesting experiment for us in how oil markets function. I would recommend against further SPR sales, regardless of the final outcome of the current effort. The reason is that I see the long-run challenge of meeting the growing demand from the emerging economies as very daunting, and in my mind is the number one reason we're talking about an oil price above $100/barrel in the first place.

A one-time release from the SPR, or even a series of releases until the SPR runs dry, does nothing whatever to address those basic challenges.

It's not clear how much impact this will have on prices, but if prices do drop as a result of the release, some countries may take advantage of the opportunity:

the Chinese might see a temporary drop in prices as an opportunity to add to their own SPR. To the extent that happens, we're getting back to the no-effect scenario

If we had a Strategic Job Reserve to draw upon, or something similar, e.g. an infrastructure bank, that might make a difference. But I don't think this will do much to help.

Excerpt: And a tightly controlled economy can get results quickly. That’s what happened with China’s $586 billion stimulus program introduced in 2009. Growth in gross domestic product leaped from a 6 percent rate in early 2009 back to double digits. Most of the money was channeled through government-controlled banks, whose lending increased by $1.4 trillion, or 32 percent, over the course of 2009 after being flat since early 2006. The money supply increased by 29 percent.

Those loans financed public and industrial infrastructure and real estate. Property prices in January 2010 were up 9.5 percent from a year earlier, according to government numbers, and much more by private realistic estimates. Employment gained along with economic activity, and in the third quarter of 2009, there were 94 job openings for every 100 applicants, up from 85 in depressed 2008, and close to the pre-crisis average of 97....

China’s reliance on exports and a controlled currency for growth, for instance, will no longer work if U.S. consumers are engaged in a chronic saving spree, as I believe they will be. Chinese export growth, which averaged 21 percent per year in the last decade, is bound to suffer.

Unsustainable Growth

Here’s what we should remember: This kind of growth is unsustainable, and it won’t be able to cover up China’s underlying vulnerabilities forever....

less saving and more Chinese consumption won’t substitute for weakening exports any time soon. Chinese consumers buy only about one-tenth of those in Europe and the U.S. combined. As the euro zone remains troubled, and the U.K. slashes government stimulus and U.S. consumers continue to retrench, it’s unlikely that a drop in Chinese saving could offset the negative effects of reduced exports....

Inflation Looming

Finally, China’s state-controlled economic boom may soon lead to crippling inflation. In February 2010, the director of the National Bureau of Statistics said that “asset-price increases pose a challenge for macroeconomic policy.”

The housing boom has pushed up prices to the point that apartments in Beijing are affordable to only the top 20 percent of earners -- they’re selling at about 22 times average income (average U.S. house prices peaked at six times average income). A square meter of property in China costs an estimated 164 times per-capita income, compared with 33 times in high-priced Japan.

The 2009 stimulus package also spurred consumer price inflation to a year-over-year acceleration of 5.5 percent in May. Food prices are very sensitive politically because so many Chinese are at subsistence incomes, and they rose 11.7 percent in May from a year earlier.

Excerpt: Despite Chinese government's efforts to rein in liquidity by hiking rates and raising the reserve limit to an unprecedented 21%, the consumer inflation index has risen 5.5% over the past year. That level is a three years high, according to figures released by Chinese government on Tuesday.

In China, the persistence of inflation pressure has brought “shadow banking” into a topic of hot debate recently. According to a study issued by the People's Bank of China in 2010, non-banking sector lending has expanded to 63.3 trillion Yuan, ($10 trillion), 44.4% of total lending activities of China's economy.

Shadow banking, a concept coined by the US Federal Reserve, refers to non-banking financial institutions with some banking functions, but they are not or less regulated like a bank. In the U.S., the lack of regulation for the securitization of traditional financial products, including home loans, was one of the major causes of the financial crisis.

Shadow banking in China mainly exists in the form of "Bank and Trust Cooperation", the underground financing networks; but small loan companies and pawn shops also play a role in these shadow financing activities.

While mortgage securitization is not an issue in China, the “Bank and Trust Cooperation” is a vehicle to provide 'hidden' loans to enterprises outside the scope of the bank's reserve limit. Similar to the credit securitization problems in the US, the banks play the role as an intermediary. They charge service fees and commissions for services provided, while referring the securitized loans to banks customers, and raising funds off the bank's balance sheet.

Data released on March 31th, by China Trustee Association, shows that the scale of Bank and Trust Cooperation as has already reached to 15.3 trillion yuan ($2.35 trillion). The risks of such financial arrangements are asymmetrically transferred to buyers. Since no credit ratings are available for these debts, the buyers have to blindly follow the bank's referrals, hoping the banks, which make money from commissions and fees no matter what happens with the loan, have done due diligence and are honest.

Fortunately, unlike the mortgage backed securities that traumatized the US economy, the assets of China's “Bank and Trust Cooperations” are yet to enter the stage of complex financial leverage. Also last January, the CBRC ordered commercial banks to incorporate this type of lending into their balance sheets by the end of this year....

Shadow banking in China will continue to grow as long as commercial bank lending is unable to meet liquidity demand and interest expectation. However the scale of shadowing banking is undermining the effectiveness of monetary tools to combat inflation. Since last October, China's central bank has raised reserve requirement ratio nine times already, but the inflation pressure still remain high.

Early in May, the Chairman of the China Banking Regulatory Commission, Mr. Liu Ming Kang spoke out at the 22nd committee meeting, claiming that one of the major risks the banking system faces is 'shadow banking'. This is the first time that the CBRC has raised the red flag. Such a statement indicates the increasing uneasiness the regulatory body is having, while trying to engineer a soft-landing.

Excerpt: The rot and decay at the heart of the global financial system is deepening and extending. This is the conclusion to emerge from the annual report of the Bank for International Settlements (BIS) released on Sunday.

The BIS, sometimes referred to as the central bankers’ bank, was one of the few institutions that pointed to the dangerous imbalances in the global financial system that led to the collapse of Lehman Brothers in September 2008. Three years on its annual report gives clear indications that another financial crisis is in the making.

One of the biggest dangers comes from the massive assistance provided by central banks to the banks and financial institutions through ultra-low interest rates and interventions into debt markets. The third consecutive year of “extremely accommodative financial conditions” coupled with “near zero interest rates in the core advanced economies increasingly risk a reprise of the distortions they were originally designed to combat.”

The extent of this intervention is indicated by the growth of central banks’ balance sheets to “an unprecedented size.” In response to the financial crisis, the US Federal Reserve and the Bank of England have both increased their assets from 8 percent of gross domestic product (GDP) to around 20 percent, while the increase in the Eurosystem is from 13 percent to more than 20 percent of euro area GDP....

The BIS has called on governments to take “swift and credible action” to bring down debt levels. But this does not mean a return to the pre-crisis situation. So-called “structural tasks” have to be addressed. “In many countries ... [this] involves facing up to the fact that, with their populations ageing, promised pension schemes and social benefits are simply too costly to sustain.”

That is, large portions of the social welfare measures enacted in the post-war period must be wiped out to pay off the government debts incurred as a result of the bailout of the banks. The BIS insists that a return to the “pre-crisis fiscal stance will not be enough” for at least two reasons. Pre-crisis fiscal positions looked “too rosy” because of the tax revenues from asset price booms; and surpluses must be built up to act “as buffers that can be used for stabilisation in the future.” In other words, the working class must be made to pay not only for the past crises created by the banks but for future ones as well....

Excerpt: The Washington Post discussed this truism last week in an article titled Five economic lessons from Sweden, the rock star of the recovery.

What were those five lessons?

1. Keep your fiscal house in order when times are good, so you will have more room to maneuver when things are bad.

Prior to the 2008-09 recession, the U.S.and Britain had budgets deficit equal to 3% of GDP. Sweden had a 3.6% surplus. Sweden’s gross debt is ~45% of its economy; the US is nearly 100%. This left the government with lots of flexibility to engage deficit spend when the economy hit a crisis.

2. Fiscal stimulus can be more effective when it is automatic.

Sweden’s response to the crisis was provide income, health care and other services to people who are unemployed. That prevented a paradox of thrift from making a minor redcession something much worse.

Their spending programs cushioned economic blows, and can be designed to taper off when the economy turns.

3. Use monetary policy aggressively

As aggressively as the Federal Reserve has responded to the financial crisis, the Swedish central bank was even more aggressive. The Riksbank lowered its target short-term interest rate nearly to zero, but it expanded the size of its balance sheet even more than the Fed did relative to the size of its economy. In the summer 2009, the Riksbank balance sheet was more than 25% of GDP. The Fed, never got over 15%. And, Sweden was much faster to normalize their footing versus the Fed, who is still zero bound. Swedish central bank have already raised rates.

4. Keep the value of your currency flexible.

The Swedish krona was a helpful buffer against the economic downdraft of the past few years. It fell in value against both the dollar and the euro during the crisis, making Swedish exporters more competitive.

5. Bankers will always make blunders; just make sure they don’t doom the economy.

Swedish banks made mistakes, just like the rest of the world. But their losses were more manageable. And due to their crisis in the 1990s, where Sweden’s major banks were temporarily nationalized, Bankers were not cushioned from the consequences of their unwise decisions. They did not learn the ruinous lesson of privatized profits and socialized losses that US Bankers have turned into a motto.

Excerpt: Hoenig’s concern is not for the welfare of any specific bank or even the banking system, but rather for the entire capitalist system itself:

“How can one firm of relatively small global significance merit a government bailout? How can a single investment bank on Wall Street bring the world to the brink of financial collapse? How can a single insurance company require billions of dollars of public funds to stay solvent and yet continue to operate as a private institution? How can a relatively small country such as Greece hold Europe financially hostage? These are the questions for which I have found no satisfactory answers. That’s because there are none. It is not acceptable to say that these events occurred because they involved systemically important financial institutions.

Because there are no satisfactory answers to these questions, I suggest that the problem with SIFIs is they are fundamentally inconsistent with capitalism. They are inherently destabilizing to global markets and detrimental to world growth. So long as the concept of a SIFI exists, and there are institutions so powerful and considered so important that they require special support and different rules, the future of capitalism is at risk and our market economy is in peril.”

Hoenig’s comments on the decline in competition and accountability in banking are especially noteworthy:

“The U.S. economy is the most successful in the history of the world. It achieved this success because it is based on the rules of capitalism, in which private ownership dominates markets and individuals reap the rewards of their success. However, for capitalism to work, businesses, including financial firms, must be allowed, or compelled, to compete freely and openly and must be held accountable for their failures. Only under these conditions do markets objectively allocate credit to those businesses that provide the highest value. For most of our history, the United States held fast to these rules of capitalism. It maintained a relatively open banking and financial system with thousands of banks from small community banks to large global players that allocated credit under this system. As late as 1980, the U.S. banking industry was relatively unconcentrated, with 14,000 commercial banks and the assets of the five largest amounting to 29 percent of total banking organization assets and 14 percent of GDP.

Today, we have a far more concentrated and less competitive banking system. There are fewer banks operating across the country, and the five largest institutions control more than half of the industry’s assets, which is equal to almost 60 percent of GDP. The largest 20 institutions control 80 percent of the industry’s assets, which amounts to about 86 percent of GDP.”

Excerpt: In theory, the GOP is so committed to resisting tax hikes because it’s so committed to creating jobs. “The fact is you can’t tax the very people that we expect to invest in the economy and create jobs,” says Speaker John Boehner. But Michael Linden’s chart comparing average annual job creation at different marginal tax rates begs to differ: "must see" chart

Excerpt: In the fourth quarter of 2008, the dollar’s value share of all countries’ foreign reserve holdings was 64.1 percent. That share had decreased by 2.7 percentage points by the end of 2010. The dollar’s value share of advanced countries’ reserves was 67.2 percent and decreased by 3.1 percentage points over the eight-quarter period. The euro’s value share in all countries’ reserves decreased slightly over this period, from 26.4 percent at the end of 2008 to 26.3 in the fourth quarter of 2010. On the other hand, the euro’s share of advanced countries’ reserves increased by 2.2 percentage points, from 22.4 percent in the fourth quarter of 2008.

The dollar’s quantity share of all reserves was 66.8 percent in the last quarter of 2008 and 63.3 percent in the last quarter of 2010, a drop of 3.5 percentage points.1 The dollar’s quantity share of advanced countries’ reserves dropped 3.6 percentage points....

The published aggregate IMF COFER data suggest a general diversification away from dollars from the end of 2008 to the end of 2010 with a significant shift toward the euro. However, a substantial portion of this apparent shift away from the dollar can be explained by the Swiss National Bank’s large-scale purchases of foreign exchange over this period combined with the Bank’s preference for euro-denominated assets. Similarly, the shift to euro-denominated assets is largely the consequence of the Swiss National Bank’s operations.

Tuesday, June 28, 2011

Excerpt: George Soros spoke in Vienna today and believes that the endgame for the Euro crisis will result in smaller nations defecting from the Euro. He said that Europeans will ultimately require a mechanism that allows for some sort of defection. Bloomberg quoted Soros as saying the crisis is developing and could result in collapse:

“I think most of us actually agree that (the Euro crisis) is actually centered around the euro… It’s a kind of financial crisis that is really developing. It’s foreseen. Most people realize it. It’s still developing. The authorities are actually engaged in buying time. And yet time is working against them.”

“We are on the verge of an economic collapse which starts, let’s say, in Greece, but it could easily spread.”

“The financial system remains extremely vulnerable.”

Soros is one of the few who has long understood the fundamental problem in Europe. The single currency system imposes a recessionary bias on countries due to the lack of a central treasury and mechanism that can offset the inherent trade imbalance that results from the lack of floating exchange rates between differing economies. Much like the gold standard once imposed, these trade imbalances ultimately result in unsustainable debt growth via budget deficits. The Europeans MUST resolve this central weakness in the Euro or the issues will persist and emerge time and time again in the years ahead.

I still think this means one of two things – Europe must become more like a version of the USA (or a United States of Europe) or they must allow the entire EMU to crumble while reverting back to some form of independent currency systems throughout Europe that existed previously. I don’t think that’s an option at this juncture. Too much time and effort has been invested in the EMU for it to be allowed to crumble at this point. What the Europeans need to resolve is the size of this United States of Europe. I don’t doubt that Soros could be right about defections, however, that would require the acceptance that defections are likely to include defaults and serious economic disruption. For a world that is enamored with bailouts and helping bankers at all costs I find it hard to believe that the Europeans will allow such a destructive result.

Excerpt: In this morning’s note David Rosenberg has some good thoughts on the state of the recovery and why he sees H2 headwinds. More interestingly though, he discusses why the recovery has been largely artificial:

“What most economists are missing in their second half recovery prospects is the huge amount of fiscal withdrawal coming out way. And this retrenchment is ongoing at the state and local government levels where the muni bond bears earlier this year totally missed the situtation….

Indeed, this 2009-2011 recovery and cyclical bull market has been as artificial as the 2003-2007 expansion. That last one was fueled by financial engineering in the financial sector. This one is being underpinned by unprecedented government intrusion in the credit markets. As of this quarter, your government has replaced the private sector as the largest source of outstanding mortgage market and consumer related credit. So not only is the USA turning Japanese in many respects, it is also now resembling China where the government also redirects the flow of private sector credit.”

That’s life during a balance sheet recession. With the private sector in saving and debt paying mode government has been forced to step in and bear the burden. Get used to it. This “artificial” economy is far from making an exit. And if austerity comes in the next few quarters as Rosenberg sees then “extended period” might become something closer to resembling “permanent period”. Any economic downturn at this juncture has the potential to prolong the balance sheet recession.

Excerpt: China’s first audit of local government debt found liabilities of 10.7 trillion yuan ($1.7 trillion) at the end of last year and warned of repayment risks, including a reliance on land sales.

Financing vehicles set up by regional authorities already had more than 8 billion yuan in overdue debt, while more than 5 percent of such companies used new bank borrowing to repay loans, according to the audit, posted on the National Audit Office’s website and submitted to China’s cabinet.

“Some local government financing platforms’ management is irregular, and their profitability and ability to pay their debt is quite weak,” Liu Jiayi, the country’s auditor-general said in speech published today.

Excerpt: China plans to stimulate domestic demand and reduce its foreign trade surplus to encourage balanced trade growth, premier Wen Jiabao said on Sunday during the British leg of a visit to Europe.

He made the comments during a tour of the Chinese-owned Longbridge MG Motor factory in Birmingham, central England, where he unveiled the first new MG Motor model in 15 years.

He also repeated his assurance that China would remain a long-term investor in European sovereign debt, saying China would lend to those countries experiencing difficulty borrowing.

"China has no intention to pursue a trade surplus," he told BBC television through a translator.

"What we want is to have balanced and sustainable growth of trade. At home we are going to further stimulate domestic demand and we are going to reduce our foreign trade surplus and our reliance on exports," he said.

Excerpt: The strength of the U.S. economy depends on whether you believe optimists like Mark Zandi or pessimists like David Rosenberg.

Economists Zandi and Neal Soss, who project sustained growth during the next six months, agree with Federal Reserve Chairman Ben S. Bernanke that the recent slowdown in consumer spending, manufacturing and gross domestic product will be transitory. They point to two years of expansion in the world’s largest economy and rising corporate profits as signs that GDP is poised to pick up.

The U.S. is “measurably stronger today than a year ago,” said Zandi, chief economist for Moody’s Analytics Inc. in West Chester, Pennsylvania. “You can see it in the job market. At that time, job growth had just started to resume; now 2 million private-sector jobs have been created.”

Rosenberg and Ethan Harris predict the U.S. will struggle as some fiscal-stimulus programs end and federal, state and local governments continue to slash budgets. Companies aren’t likely to use their record earnings to accelerate hiring, the economists say, while no one knows exactly how long it will take to resolve the European debt crisis and repair factories in Japan following the earthquake and tsunami.

“To say that the air pocket that we hit in the first quarter was all transitory is a mistaken view,” said Rosenberg, chief economist at Gluskin Sheff & Associates Inc. in Toronto. “The whole recovery’s been a soft patch.” Another recession “is practically baked in the cake, barring another round of policy stimulus.”

Excerpt: Month over month lending in the Chinese shadow banking system continues to report astounding growth numbers. Most of this is due to tighter lending and underwriting standards in the more formal channels. This suggest to us that despite their best efforts the central committee is having a tough time regulating the explosive growth in credit that now very much threatens their ongoing expansion....

Pump up the Volume

As interest rates have risen we are unsurprised to see these lending volumes grow. As was the case at the height of the US based lending boom, people fled the traditional mortgage originators and went to the cheapest money they could find – often coming in the form over very flimsy and opaque financial institutions.

We fear China is now experiencing the same kind of build up. But as they say, “on with the show!...

More signs that investors and those seeking liquidity are going for non-traditional sources of funding is reflected in the forward looking volume expectations....All of the above noted, the first signs of weakness are starting to show. As if often the case in markets that are rolling over, we are seeing a true lack of forward pricing power....

Deadbeats Rising

And, the final chapter of this first book suggests to us that our hero – private sector lending – is very much in trouble. While delinquent loans haven’t quite lead to Maddoff like negative cash flows, the month over month increase is meaningful.

With Shibor having rocketed up to new heights over the last week, the idea of a soft landing may have evaporated along with the once tight spread. If a correction in property comes and financial institutions are impaired China will need all of the current account surplus they can find to clean up the books. They have been doing this already in failed muni loans.

Excerpt: A 30-year war for energy preeminence? You wouldn’t wish it even on a desperate planet. But that’s where we’re headed and there’s no turning back....

Why 30 years? Because that’s how long it will take for experimental energy systems like hydrogen power, cellulosic ethanol, wave power, algae fuel, and advanced nuclear reactors to make it from the laboratory to full-scale industrial development. Some of these systems (as well, undoubtedly, as others not yet on our radar screens) will survive the winnowing process. Some will not. And there is little way to predict how it will go at this stage in the game. At the same time, the use of existing fuels like oil and coal, which spew carbon dioxide into the atmosphere, is likely to plummet, thanks both to diminished supplies and rising concerns over the growing dangers of carbon emissions....

The Existing Energy Lineup

To appreciate the nature of our predicament, begin with a quick look at the world’s existing energy portfolio. According to BP, the world consumed 13.2 billion tons of oil-equivalent from all sources in 2010: 33.6% from oil, 29.6% from coal, 23.8% from natural gas, 6.5% from hydroelectricity, 5.2% from nuclear energy, and a mere 1.3% percent from all renewable forms of energy. Together, fossil fuels -- oil, coal, and gas -- supplied 10.4 billion tons, or 87% of the total.

Even attempting to preserve this level of energy output in 30 years’ time, using the same proportion of fuels, would be a near-hopeless feat. Achieving a 40% increase in energy output, as most analysts believe will be needed to satisfy the existing requirements of older industrial powers and rising demand in China and other rapidly developing nations, is simply impossible. ...

From this perspective, giant nuclear reactors and coal-fired plants are, in the long run, less likely to thrive, except in places like China where authoritarian governments still call the shots. Far more promising, once the necessary breakthroughs come, will be renewable sources of energy and advanced biofuels that can be produced on a smaller scale with less up-front investment, and so possibly incorporated into daily life even at a community or neighborhood level.

Whichever countries move most swiftly to embrace these or similar energy possibilities will be the likeliest to emerge in 2041 with vibrant economies -- and given the state of the planet, if luck holds, just in the nick of time.

Excerpt: What really struck me in Skidelsky's account, however, was the extent to which conventional opinion in the 1920s viewed high unemployment as a good thing, a sign that excesses were being corrected and discipline restored--so that even a successful attempt to reflate the economy would be a mistake. And one hears exactly the same argument now. As one ordinarily sensible Japanese economist said to me, "Your proposal would just allow those guys to keep on doing the same old things, just when the recession is finally bringing about change."

In short, in Japan today--and perhaps in the United States tomorrow--behind many of the arguments about why we can't monetize our way out of a recession lies the belief that pain is good, that it builds a stronger economy. Well, let Keynes have the last word: "It is a grave criticism of our way of managing our economic affairs, that this should seem to anyone like a reasonable proposal."

Excerpt: Since this round of budget talks began, in early May, the Obama administration and the Democrats have retreated steadily before the demands of the Republican right, although the Republicans control only the House of Representatives, while the Democrats hold both the Senate and the White House.

The Democrats began the talks by accepting two of the three main conditions set by the Republicans: that any measure to raise the debt ceiling should be tied to massive cuts in domestic spending, particularly in entitlement programs like Medicare, Medicaid and Social Security; and that the dollar amount of the increase in the debt ceiling would be matched, dollar-for-dollar, by the amount of deficit reduction.

The third condition set by the Republicans, and dramatized by their walkout Thursday, is that the deficit reduction come exclusively from spending cuts, with no increase in taxes on any section of the wealthy or big business.

The so-called breakdown of the talks Thursday was a largely orchestrated affair, designed to allow the Democrats to posture as advocates of tax increases for the wealthy and corporate interests before their inevitable and completely predictable cave-in.

The “collapse” and subsequent resumption of the budget talks were likely prepared the night before Cantor’s much-publicized “walkout,” when House Speaker John Boehner visited the White House Wednesday night for a closed-door meeting with Obama, which went unreported for several days.

It’s all unfolding like a slow motion train wreck. The underlying deflationary forces were temporarily masked when QE2, under the misconception that it was somehow inflationary, caused global portfolio managers to exit the dollar, both directly and indirectly.

But now that psychology is fading, as the global lack of aggregate demand revealing the actual spending power just isn’t there to support things at the prices managers paid to place their bets. And the next ‘really big shoe’ (as Ed Sullivan used to say) to fall could be China, as they move into their traditionally weaker second half.

Excerpt: Is our 1937 moment in the not too distant future? It’s beginning to look that way. House Republicans are using the debt ceiling debate as their bargaining chip to “cut, cap and balance”. According to The Hill this means:

Cut — Substantial cuts in spending that will reduce the deficit next year and thereafter.

Cap — Enforceable spending caps that will put federal spending on a path to a balanced budget.

Balance — Passage of a balanced-budget amendment to the U.S. Constitution — but only if it includes both a spending limitation and a supermajority for raising taxes, in addition to balancing revenues and expenses....

With the US now running a current account deficit of 4% it is imperative that the government sector run a deficit in excess of 4% in order for the private sector to be able to save. If this were not the case, the private sector would be forced into deficit and the economy would contract. This occurred repeatedly in Japan in the 90′s and is currently occurring in the periphery nations of Europe. Austerity is not helping as so many said it would in 2008. Instead, it is causing near depression throughout the region. Were it not for 10% budget deficits in the USA you can be certain that we would be suffering a similar economic decline. Fortunately, we have not allowed ourselves to be scared by the persistent fear mongering with regards to our imminent (mythical) insolvency.

Cut, cap and balance is genius politics if you’re trying to send President Obama out in 2012 as the worst President of all-time, but it’s awful economics (yes, it was awful economics under Clinton as well) and the equivalent of walking the US economy out on the plank. The details here are still early in the making, but if we do indeed pass harsh cuts and enforce a balanced budget amendment in the coming years I would get extraordinarily bearish on the outlook for the US economy. 1937 here we come?

The United States faces a serious long-term deficit problem and an immediate short-term problem of slow growth and high unemployment. Current economic and budget conditions in the United States do not look at all like the conditions in countries that have experienced successful deficit reduction through short, sharp fiscal contractions. Non-partisan experts like Fed Chairman Bernanke and the Congressional Budget Office warn against cutting deficits too fast. And as the non-partisan Congressional Research Service concludes from its analysis of the international evidence, cutting budget deficits too rapidly under current U.S. economic conditions is most likely to hurt the economy and ultimately be unsuccessful. If we go down this path, I’m afraid the lesson will be “Spend Less, Grow Less, Slow the Economy.”

By the way, here is the nonpartisan Congressional Research Service's assessment of contractionary fiscal expansions. (If only our Congressional members read these reports...)

Excerpt: So, just to summarize: Republicans are deeply, deeply concerned about the budget deficit; they believe that our nation’s future is at stake.

But they’re willing to sacrifice that future, not to mention risk the good faith and credit of the federal government, rather than accept so much as a single penny of tax increases as part of a deal.

Given all that, it seems almost redundant to mention that federal tax receipts as a percentage of GDP are near a historic low: (chart)

So what’s it all about? The answer, of course, is that the GOP never cared about the deficit — not a bit. It has always been nothing but a club with which to beat down opposition to an ideological goal, namely the dissolution of the welfare state. They’re not interested, at all, in a genuine deficit-reduction deal if it does not serve that goal.

And everyone who has preached bipartisanship, who has called for a meeting of minds on the subject, is either a fraud or a chump.

Investors are withdrawing cash from money market funds heavily exposed to short-term debt issued by European banks out of fear that a Greek default could spark contagion across the region’s financial sector.

At the same time there is increasing reluctance among US banks to lend to their European counterparts in the past two weeks because of growing worries over Greece, according to brokers and bank traders.

You know, scratch that. Let me quote from last May’s post on BBVA’s problems in the US commercial paper market:

The Wall Street Journal is reporting that the Spanish bank Banco Bilbao Vizcaya Argentaria (BBVA) is having a difficult time funding itself in the US commercial paper market. Moreover, according to the Journal this has been going on for some time – since the beginning of the month. The amount is small ($1 billion) given BBVA's large balance sheet which is almost $700 billion, the same as when the crisis started in 2007. And BBVA is widely seen, along with Banco Santander, as the healthiest institution in Spanish banking. Their having problems rolling over paper speaks to the panic of CP buyers, in my view. But the commercial paper market has also been a major source of bank runs since the credit crisis began and this has to be seen by authorities in the US and Europe as a signal of liquidity problems…

What do I make of this? For starters, I don't think it is entirely rational because the two entities I identified are the strongest in their respective markets. These stories have all the hallmark of panic. Yet, it speaks to a certain Eurozone debt revulsion that is now widespread.
-European Contagion Spreads; Is This Rational?

Excerpt: More Americans applied for unemployment benefits last week, adding to evidence that the job market is weakening.

The Labor Department says applications rose by 9,000 to a seasonally adjusted 429,000 last week. It was the second increase in three weeks and the biggest jump in a month. Applications have been above 400,000 for 11 straight weeks.

Applications dipped below 400,000 in February and stayed below that threshold for seven of the following nine weeks. Applications fell as low as 375,000, a level that signals sustainable job growth. But applications surged in April to an eight-month high of 478,000 and have shown only modest improvement since that time.

Excerpt: The New York Stock Exchange said Tuesday margin debt fell 1.7% in May, the first decline since a marginal slide in August.

At the end of May, margin debt totaled $315.38 billion, retreating from April's $320.71 billion, which was the highest level since February 2008, according to Big Board data for customers of NYSE-member securities firms.

Those trading "on margin" take on a risk in exposing themselves to margin calls during a sharp decline in stock prices, which require them to post additional collateral lest their brokers sell their securities to cover the debt. A wave of margin calls can worsen selling pressure on stocks, a phenomenon that some say contributed to the market's plummet during the financial crisis.

Excerpt: Yesterday, the HSBC China PMI flash estimate shows that manufacturing is probably not growing at all in June. With the latest reading at 50.1, it is pretty much getting ever closer to downright contraction territory.

This is by no means surprising though. As I have pointed out time and again, as the Chinese government and the People’s Bank of China tighten the policy, economic slowdown is bound to happen. The only question is when and how slow. As we have gotten more data over the past few months, my sense is that the inflation and property prices remain very sticky. With the mixed bag of economic data coming in in the previous weeks, I can only confirm that the economy has slowed, but definitely not slow enough to solve the biggest problems.

It will remain necessary for the People’s Bank of China to raise interest rates and reserve requirement ratio, in my view, as the inflation and property prices problems remain unsolved. However, the impact of that is a further tightening of liquidity of the Chinese banking system. Indeed, we have been seeing large surges in interbank rates in recent days, with one-week Shanghai Interbank Offered Rate (SHIBOR) shot pass 9% now.

Source: SHIBOR

Although the stated objective of price stability has not been met, the monetary and credit tightening is affecting the economic growth in a negative way. I have been early to warn about the dire situation among small businesses in China, who are struggling with the lack of credit and labour, as well as power shortages. I have also been early to warn the growth in underground credit due to the lack of bank credit, in which small companies are paying exceptionally high interest rates to keep themselves afloat.

Unfortunately, that is still not enough to bring inflation and property prices down. So far, the data points are still confirming my previous conjecture that China needs a recession, or a drastic slowdown, to bring inflation down. As tightening continue, I believe the risk of hard landing to increase, and I believe we can only see easing after we see more meaningful decrease in inflation and significant correction in the real estate market.

NEW YORK (MNI) - U.S. money market funds, fearing indirect risk from Greek debt via the commercial paper of European banks, are exiting such holdings and putting money into Treasuries, or executing reverse repos in the overnight market, Treasury traders said.

But finding Treasury bills to buy is no easy task, traders said, as so many other accounts also are buying them that yields are at zero interest, if not negative.

"The money funds have cash," one trader said. "If they have excess cash, they can do a reverse repo with a primary broker. They are lending money on a collateralized basis. They can give money to the institutions, who give them back collateral. But they want something safe. So now the money market funds have absorbed all the safe collateral.

"They is why the Treasury repo rate is going to zero percent, and why T-bill rates are going to zero," he added.

Traders said some money market funds are putting money into the overnight market and/or in buying T-bills as they do not want to have inadvertent exposure to the Greek situation through the European banks. And in some cases they want to borrow the bills from a bank through the overnight repo market.

"Some of the banks, with the headline risk of Greece, Italy etc., are doing that," one trader said. "They are seeing a flight to quality. That is why you will see some of the overnight repo markets on Treasuries are trading negative" rate as money market funds invest money in such assets.

Excerpt: Yasuteru Yamada, a 72-year-old former anti-nuclear activist, will lead a band of pensioners to the Fukushima Dai-Ichi plant early next month to help clean up the site of Japan’s worst atomic disaster since World War II.

Yamada, a retired Sumitomo Metal Industries Ltd. (5405) plant engineer, is waiting for Tokyo Electric Power Co. to allow his volunteer “Skilled Veterans Corps” to carry out preliminary inspections at the plant after the government welcomed the move.

Almost four months after the March 11 earthquake and tsunami triggered the crisis by damaging the Dai-Ichi plant, 3,514 workers involved in the clean-up have been exposed to radiation, including nine whose readings breached the annual limit of 250 millisieverts for a nuclear plant worker. Tepco said it had 1,044 workers at the plant as of June 19, about half the number a month earlier.

“I’m not on a suicide mission,” said Yamada, a 1962 graduate of Tokyo University. “I am going to try my best to protect myself and come back alive.”...

Five-Member Team

“People who are willing to sacrifice their daily lives to help the nation resolve these problems are invaluable,” Goshi Hosono, special advisor to Prime Minister Naoto Kan, said in a news briefing in Tokyo today. “First we’ll have to check on their health status, as people at an advanced age working in that kind of environment could fall ill.”...

Yamada and his fellow pensioners said they’re aware of the risks of entering the nuclear station.

“I am mentally prepared for death, but I’m not a kamikaze,” Yamada said, referring to the Japanese soldiers who carried out suicide attacks during World War II. “The kamikaze were making irrational, obligatory self-sacrifices. What I’m doing is self-motivated and rational.”

Excerpt:“We do not see principal reduction as a solution that should or can be used on a broad basis,” Bank of America spokesman Rick Simon said.

States aren’t the only ones struggling to get banks on board. A year-old Federal Housing Administration effort that pays lenders to write down second liens and refinance underwater debt has drawn only 207 takers so far.

In all, banks wrote down principal on fewer than 5,000 loans in the fourth quarter of 2010, according to the Office of the Comptroller of the Currency.

About 23 percent of U.S. homes have negative equity totaling about $750 billion, as reported by CoreLogic. In contrast, the biggest banks combined hold a total of $717 billion in Tier 1 capital, according to Bloomberg data.

As states continue to negotiate with banks, they also are coping with borrowers who seem fatigued by a flood of aid programs that so far haven’t helped much....

consumer advocates say such aid is long overdue. Homeowners innocently swept into the run-up in home prices are now bearing the financial and psychological burden of a mortgage they might never be able to repay.

“There was a lot of money put into rescuing the banks and not nearly the resources put into rescuing regular folks,” said Bruce Mirken of the Greenlining Institute, an economic policy group in Berkeley, California. “A fair number of these loans were written based on fantasy values. It’s better for everybody concerned to have a mortgage market and a housing market that has some connection to reality.”

Excerpt: As Congress bickers over how to cut the deficit, some economists warn that cuts too deep too soon would endanger the recovery. Unfortunately, spending has already declined on the state and local government levels. As a result, we're seeing weaker results in the two economic indicators that matter the most: hiring and economic growth. Without the headwind created by the state and local governments, the recovery would look significantly stronger....

A Recovery With 326,000 More Jobs

In March 2010, the U.S. economy finally began to add jobs again. Every month since then, private sector employment has grown. Yet almost every month since then, state and local governments have cut jobs. Without those layoffs, the U.S. labor market would have 326,000 more people employed through May 2011. Here's a chart showing job growth with and without the impact of state and local government cuts: (chart)

How much better would we feel about the U.S. economy having grown by 3.4% and 2.4% over the past two quarters instead of 3.1% and 1.9%? This change would have both tangible and intangible positive effects on the economy. Not only would there have been more money spent to stimulate the economy, but sentiment would be a little higher, as growth would be looking a little bit better.

A Taste of What's to Come?

Remember, all of these benefits to the economy would have come merely if state and local governments didn't cut jobs or spending -- not if they had hired or had increased spending compared to 2009 levels. To be sure, budget troubles are forcing state and local austerity, but if the federal government were able to stop their bleeding, then the recovery would be proceeding with greater strength. The additional money and jobs in the economy would help to stimulate a higher rate of growth going forward as well, which means we'll miss the impact of this lost economic activity in quarters to come as well.

Excerpt: The federal budget deficit is a distraction. It’s important, yes, and must be addressed. But by a wide margin, it’s not the nation’s most pressing economic problem. That would be the widespread and persistent joblessness...

Almost 14 million people ... were officially counted as unemployed last month. But that’s just the tip of the iceberg. There were almost 9 million part-time workers who wanted, but couldn’t find, full-time jobs; 28 million in jobs they would have quit under normal conditions; and an additional 2.2 million who wanted work but couldn’t find any and dropped out of the labor force.

If the economy could generate jobs at the median wage for even half of these people, national income would grow by more than 10 times the total interest cost of the 2011 deficit (which was less than $40 billion). So anyone who says that reducing the deficit is more urgent than reducing unemployment is saying, in effect, that we should burn hundreds of billions of dollars worth of goods and services in a national bonfire.

Excerpt: The Payroll Tax Needs a Vacation, by Robert Frank, Commentary, NY Times: The federal budget deficit is a distraction. It’s important, yes, and must be addressed. But by a wide margin, it’s not the nation’s most pressing economic problem. That would be the widespread and persistent joblessness...

Almost 14 million people ... were officially counted as unemployed last month. But that’s just the tip of the iceberg. There were almost 9 million part-time workers who wanted, but couldn’t find, full-time jobs; 28 million in jobs they would have quit under normal conditions; and an additional 2.2 million who wanted work but couldn’t find any and dropped out of the labor force.

If the economy could generate jobs at the median wage for even half of these people, national income would grow by more than 10 times the total interest cost of the 2011 deficit (which was less than $40 billion). So anyone who says that reducing the deficit is more urgent than reducing unemployment is saying, in effect, that we should burn hundreds of billions of dollars worth of goods and services in a national bonfire.

Excerpt: I don't see why the aggregate state funding gap is not numero uno on the 'risks' to the US outlook (I usually hear oil, Europe, China, etc., in my line of work). According to the Center on Budget and Policy Priorities, the State budget gap is not expected to clear at least through 2013. From the CBPP report "States Continue to Feel Recession's Impact":

Three years into states' most severe fiscal crisis since the Great Depression, their finances are showing the clearest signs of recovery to date. States in recent months have seen stronger-than-expected revenue growth.

This is encouraging news, but very large state fiscal problems remain. The recession brought about the largest collapse in state revenues on record, and states are just beginning to recover from that collapse. As of the first quarter of 2011, revenues remained roughly 9 percent below pre-recession levels.

Consequently, even though the revenue outlook is better than it was, states still are addressing very large budget shortfalls.

Better put: state revenues are rising more quickly than expected from a low base following the most precipitous drop 'on record'. Not feeling too confident here....

The trend for job growth has been decidedly negative for state and local governments. State and local governments have net-fired workers every single month since November 2010....

Federal government support to state and local governments is set to decline significantly next year (see figure 2 on html of CPBB report). So it's up to the private sector to provide sufficient income growth to offset the likely decline (latest data is 2009) by the giant of aggregate compensation, state and local governments, for years to come. I'm skeptical.

Excerpt: Global imbalances continue to place the stability of the global economy at risk. The International Monetary Fund’s forecasts anticipate essentially no reduction in existing imbalances in the next five years, assuming the continuance of current policies. And independent observers have suggested that, if anything, the IMF may be overly optimistic about the prospects. A shock that causes those imbalances to unravel quickly could lead to sharp drops in the currencies of countries that depend most heavily on foreign finance for their current-account deficits (“countries that depend most heavily on foreign finance” being code for the US). That in turn could have major repercussions, both real and financial. As the IMF puts it, the global economic recovery could be “resting on hollow legs.”

Admittedly, not a few of us have warned before about the risks posed by global imbalances and pointed to savings-investment imbalances in the US and China as their source. Some of those warnings were issued as early as 2004. That these early warnings were — how to put it politely? — premature does not mean that they were off target. They were derailed by the global financial crisis, which directed attention elsewhere. Evidence that global financial markets were seizing up had the effect, ironic in the circumstances, of inducing additional flows into the dollar, that currency being a traditional safe haven in times of financial turmoil and the US treasury market being the most liquid in the world. But simply because these warnings were early and rendered moot for a time by other events does not make them wrong.

Saturday, June 25, 2011

Excerpt: Two years after the recession ended, almost 14 million Americans are out of work, including more than 6 million who have been jobless for at least six months. Job seekers outnumber available jobs by more than four-to-one.

Yet most of the political urgency in Washington is focused on the national debt, not on the shortage of work.

Now, some of President Barack Obama’s staunchest supporters -- including congressional Democrats, union leaders, and former administration economists Lawrence Summers and Christina Romer - - are calling for new government initiatives to drive down the nation’s 9.1 percent unemployment rate. ...

Even with the clamor, the president hasn’t presented a comprehensive plan to provide work for the bulk of the unemployed anytime soon. The jobless rate won’t fall below 8 percent until 2013, according to the median forecast of 65 economists surveyed by Bloomberg. After an $830 billion stimulus program failed to cut unemployment as much as the administration had predicted, and with Republicans poised to block new spending, Obama has few major policy options left.

Excerpt: I have never been more desperate to explain and more hopeful for your understanding of any single fact than this: The protests in Greece concern all of you directly.

What is going on in Athens at the moment is resistance against an invasion; an invasion as brutal as that against Poland in 1939. The invading army wears suits instead of uniforms and holds laptops instead of guns, but make no mistake – the attack on our sovereignty is as violent and thorough. Private wealth interests are dictating policy to a sovereign nation, which is expressly and directly against its national interest. Ignore it at your peril. Say to yourselves, if you wish, that perhaps it will stop there. That perhaps the bailiffs will not go after the Portugal and Ireland next. And then Spain and the UK. But it is already beginning to happen. This is why you cannot afford to ignore these events....

The first bail-out was designed to help Greek people, but unfortunately failed. It was not. The first bail-out was designed to stabilise and buy time for the Eurozone. It was designed to avoid another Lehman-Bros-type market shock, at a time when financial institutions were too weak to withstand it. In the words of BBC economist Stephanie Flanders: “Put it another way: Greece looks less able to repay than it did a year ago – while the system as a whole looks in better shape to withstand a default… From their perspective, buying time has worked for the eurozone. It just hasn’t been working out so well for Greece.” If the bail-out were designed to help Greece get out of debt, then France and Germany would not have insisted on future multi-billion military contracts. As Daniel Cohn-Bendit, the MEP and leader of the Green group in the European Parliament, explained: “In the past three months we have forced Greece to confirm several billion dollars in arms contracts. French frigates that the Greeks will have to buy for 2.5 billion euros. Helicopters, planes, German submarines.”

The second bail-out is designed to help Greek people and will definitely succeed. I watched as Merkel and Sarkozy made their joint statement yesterday. It was dotted with phrases like “Markets are worried”, “Investors need reassurance” and packed with the technical language of monetarism. It sounded like a set of engineers making minor adjustments to an unmanned probe about to be launched into space. It was utterly devoid of any sense that at the centre of what was being discussed was the proposed extent of misery, poverty, pain and even death that a sovereign European partner, an entire nation was to endure. In fact most commentators agree, that this second package is designed to do exactly what the first one did: buy more time for the banks, at considerable expense to the Greek people. There is no chance of Greece ever being able to repay its debt – default is inevitable. It is simply servicing interest and will continue to do so in perpetuity.

And the biggest myth of them all: Greeks are protesting because they want the bail-out but not the austerity that goes with it. This is a fundamental untruth. Greeks are protesting because they do not want the bail-out at all. They have already accepted cuts which would be unfathomable in the UK – think of what Cameron is doing and multiply it by ten. Benefits have not been paid in over six months. Basic salaries have been cut to 550 Euros (£440) a month.

Excerpt: Here's all you need to know about the current paralysis of Fed monetary policy. The FOMC is officially forecasting an unemployment rate of 7.8%-to-8.2% by the end of 2012----3 ½ years into the "recovery"---and has decided it cannot do anything about it.

The Fed has used all of the conventional tools in its toolbox as well as some that aren't so conventional. It has kept interest rates near zero for an extended period and bought over $2 trillion in mortgages, ballooning its balance sheet to $2.8 trillion from some $800 billion in December 2007. It has also had massive help from fiscal policy including TARP, the stimulus program and numerous other policy initiatives. Despite this herculean effort the economic recovery has been by far the slowest since the great depression, and even that rate has recently diminished to a point where the Fed had to reduce its GDP growth estimates not only for 2011, but 2012 as well.

The Fed's ability to ease monetary policy any further is severely limited. Interest rates obviously cannot be reduced. The second round of quantitative easing will end as scheduled on June 30th and the Fed will not renew it---at least not anytime soon. Compared to last year when QE2 began, the rate of inflation has moved a bit higher and the imminent threat of deflation has receded. They will, however, keep reinvesting the principal of maturing securities in order to maintain the current balance sheet. Since the balance sheet will not be reduced, the end of QE2 is not generally regarded as a tightening of policy. It is well to keep in mind, however, that the average $3.8 billion that the program pumped into the economy every day will come to sudden halt. Therefore, although the end of QE2 is not an "official" tightening it may well have a similar effect.

Excerpt: Mr. Bernanke was right about stock prices, which as the nearby chart shows (via the S&P 500) began a steady climb following the chairman's QE2 announcement at Jackson Hole at the end of last August. Mr. Bernanke was attempting to promote what economists call "wealth effects," or an increase in spending that accompanies an increase in perceived wealth. Watching their assets rise in value, the argument goes, Americans will consume and invest more.

At least until the recent market correction, this part of Mr. Bernanke's strategy seemed to be going well. If you owned stocks, you had reason to feel better about the economy and your own financial circumstances.

The problem is that monetary policy is not a laser-guided missile. The Fed can create new dollars, but it can't determine where those dollars will flow in a global economy that still runs mostly on a dollar standard. And with QE2 piling on near-zero rates, dollars flooded into assets other than stocks. In particular, they flowed into emerging markets like China and Brazil and into commodities nearly across the board. The nearby chart also shows the trend in oil prices as one example of the commodity price move.

One result has been a sharp increase in food and energy prices that took gasoline up to $4 a gallon. These have produced what economists call "income effects," or a change in consumption resulting from a change in real income. People who pay $4 for gasoline, or $30 more for groceries, have less money to spend on other goods. They also tend to feel poorer, which can influence their overall confidence in the economy.

One big difference is who feels these effects. The wealth effects have helped everyone but especially the affluent. The income effects have been felt most acutely by the poor and middle classes for whom food and energy are a much higher proportion of income. QE2 and near-zero interest rates have been a boon for bankers and hedge funds. They haven't been so great for suburban families who commute to work and haul their kids to football and music practice. The monetary policy so favored by liberal economists and the White House has actively favored the wealthy over the middle class.

Could these income effects have also hurt economic growth by offsetting the wealth effects that Mr. Bernanke likes to take credit for? Mr. Bernanke concedes that oil prices are one of the "headwinds" that have hurt the recovery, so even he is admitting the possibility. The Fed blames rising oil prices on global demand and Middle East turmoil, which have played a role. But we don't think Mr. Bernanke can take credit for one set of rising asset prices but dodge all responsibility for another.

Meanwhile, the flood of dollars into emerging economies has led to inflation and property bubbles that have caused other central banks to raise interest rates or otherwise try to slow economic growth. Since these economies were leading the world out of recession, their slowdown has hurt growth in the U.S. too.

Of late, both stock and oil prices have fallen, no doubt reflecting this slower economic growth and perhaps the end of QE2. Yesterday, the White House tried to reduce oil prices further by orchestrating a world-wide release of strategic oil stockpiles. (See below.) These lower prices will flow to business and consumers, and perhaps they will help Americans feel less gloomy and cause them to spend more once again.

It was interesting to hear Mr. Bernanke say, during his press conference this week, that "as the price of oil declines"—almost as if he knew the oil stockpile release was coming. Mr. Bernanke has predicted that the oil price rise would be "temporary," so he has a reputational stake in seeing them fall as much as the Obama Administration has a political stake.

The larger economic lesson here concerns the sources of long-term growth and the limits of monetary policy. Easy money can help in a crisis, and it can raise asset prices for a while. But it cannot create a durable recovery, and to the extent it leads to bubbles and higher prices it undermines future growth and erodes middle-class incomes.

Excerpt: The Great Recession has now earned the dubious right of being compared to the Great Depression. In the face of the most stimulative fiscal and monetary policies in our history, we have experienced the loss of over 7 million jobs, wiping out every job gained since the year 2000. From the moment the Obama administration came into office, there have been no net increases in full-time jobs, only in part-time jobs. This is contrary to all previous recessions. Employers are not recalling the workers they laid off from full-time employment.

The real job losses are greater than the estimate of 7.5 million. They are closer to 10.5 million, as 3 million people have stopped looking for work. Equally troublesome is the lower labor participation rate; some 5 million jobs have vanished from manufacturing, long America's greatest strength. Just think: Total payrolls today amount to 131 million, but this figure is lower than it was at the beginning of the year 2000, even though our population has grown by nearly 30 million.

The most recent statistics are unsettling and dismaying, despite the increase of 54,000 jobs in the May numbers. Nonagricultural full-time employment actually fell by 142,000, on top of the 291,000 decline the preceding month. Half of the new jobs created are in temporary help agencies, as firms resist hiring full-time workers.

Today, over 14 million people are unemployed. We now have more idle men and women than at any time since the Great Depression....

The inescapable bottom line is an unprecedented slack in the U.S. labor market. Labor's share of national income has fallen to the lowest level in modern history, down to 57.5 percent in the first quarter as compared to 59.8 percent when the so-called recovery began. This reflects not only the 7 million fewer workers but the fact that wages for part-time workers now average $19,000—less than half the median income...

Clearly, the Great American Job Machine is breaking down, and roadside assistance is not on the horizon. In the second half of this year (and thereafter?), we will be without the monetary and fiscal steroids. Nor does anyone know what will happen to long-term interest rates when the Federal Reserve ends its $600 billion quantitative easing support of the capital markets. Inventory levels are at their highest since September 2006; new order bookings are at the lowest levels since September 2009. Since home equity has long been the largest asset on the balance sheet of the average American family, all home­owners are suffering from housing prices that have, on average, declined 33 percent (compare that to the Great Depression drop of 31 percent).

No wonder the general economic mood is one of alarm. The Conference Board measure of U.S. consumer confidence slumped to 60.8 percent in May, down from 66 percent in April and well below the average of 73 in past recessions, never mind the 100-plus numbers in good times. Never before has confidence been this low in the 23rd month of a recovery. Gluskin Sheff's Rosenberg captured it perfectly: We may well be in the midst of a "modern depression."

Nomura’s Chief Economist Richard Koo wrote a book last year called “The Holy Grail of Macroeconomics” which introduced the concept of a balance sheet recession, which explains economic behaviour in the United States during the Great Depression and Japan during its Lost Decade. He explains the factor connecting those two episodes was a consistent desire of economic agents (in this case, businesses) to reduce debt even in the face of massive monetary accommodation.

When debt levels are enormous, as they are right now in the United States, an economic downturn becomes existential for a great many forcing people to reduce debt. Recession lowers asset prices (think houses and shares) while the debt used to buy those assets remains. Because the debt levels are so high, suddenly everyone is over-indebted. Many are technically insolvent, their assets now worth less than their debts. And the three D’s come into play: a downturn leads to debt deflation, deleveraging, and ultimately depression. The D-Process is what truly separates depression from recession and why I have said we are living through a depression with a small ‘d’ right now.

Secular inflation will be non-existent

Therefore, the problem is a lack of demand for loans not a lack of supply. The Federal Reserve can print all the money it wants. But, if there is little demand for more indebtedness, it is not going to have the desired effect of permanently reflating the economy – although it can create bubbles.

The corollary of this is that inflation will be non-existent on a secular basis. For the increase in liquidity to feed into consumer price inflation, people have to actually buy more stuff. And that’s not what happens in a balance sheet recession because people are concentrated on reducing debt and increasing savings.

-Weak consumer spending will last for years, Aug 2009

For his part, the father of the Balance Sheet Recession theorem Richard Koo says QE2 drove speculation, but what about the real economy? His view is that monetary policy can aid speculative sentiment with residual feed through into the real economy but that it is largely impotent in a balance sheet recession. Only fiscal policy will have any measurable impact in driving the underlying demand side factors holding the economy back.

Excerpt: Consumption has plunged in Greece and so too have the profits of several small and mid-sized companies in the country. Many say that the government isn't doing enough to help -- and a new round of austerity could make the situation even worse....

The culprit is easy to find. The Greek private sector, which accounted for 97 percent of JEPA's orders three years ago, has collapsed . Back then, the company had business from banks, hotels and restaurants. "The private sector was going well," says Papagrigorakis. But then the Greek state was plunged into financial disaster . And now the government , as so often in the past 30 years, is making a terrible mistake, Papagrigorakis says. "Instead of shrinking the public sector, it is raising taxes."...

Papagrigorakis hardly cares what move the government makes next. They should just go ahead and raise taxes, he says with a bitter laugh. "I don't really care about taxation," he says, "as long as we're not making any profits anyway."

Excerpt: ...In 2003 Néstor Kirchner was elected to succeed the interim president, Mr. Duhalde. Mr. Kirchner embarked on a new economic model — one that his wife, Argentina’s current president, Cristina Fernández de Kirchner, continues to follow today. Its pillars are sustaining a weak currency to foster exports and discourage imports, and maintaining fiscal and trade surpluses that can be tapped for financing government and paying down debt.

Aiding this strategy has been the rising global prices of agricultural commodities. For Argentina, a major soybean producer, the commodity wave has been a godsend. Soybean prices have risen from $200 a ton in 2003 to about $500 a ton today....

The Argentine government waited until 2005, when its economy was already in recovery, to conduct the first of two debt restructurings. Nongovernment foreign investors — the biggest included pension funds from Italy, Japan and the United States — took haircuts costing them two-thirds of their investments.

Notably, the one creditor that was paid back in full — in 2006 — was the International Monetary Fund, to which Argentina owed $9.8 billion dating to the 1990s....

In the end, Argentina may have one more lesson to teach Greece: the danger of fatalism.

“A lot of people were saying that Argentina would never recover, that the peso would never regain value, that this country was damned,” said Mr. Kerner, the analyst. “And it didn’t happen.”

Excerpt: More than a third of all states allow debtors “who can’t or won’t pay their debts” to be jailed. In 2010, according to the Wall Street Journal, judges have issued 5,000 such warrants. What is behind the increased pressure to incarcerate people with debts? Is it a desire to force debt payment? Or is it part of a new structure where incarceration is becoming increasingly the default tool to address any and all social problems?

Consider a different example that has nothing to do with debts. Earlier this year, a Pennsylvania judge was convicted of racketeering, of taking bribes from parties of interest in his cases. It was a fairly routine case of bribery, with one significant exception. The party making the payoffs was a builder and operator of youth prisons, and the judge was rewarding him by sending lots of kids to his prisons.

Welcome to the for-profit prison industry. It’s an industry that wants people in jail, because jail is their product. And they have shareholder expectations to meet....

Now the War on Drugs is a substantial part of the prison-industrial complex.

The War on Drugs and this new prison industry is a template for where we seem to be heading as a culture. In the last ten years or so, a disturbing part of the system has metastasized into the system itself. As our financial system has increasingly and more overtly dominated the very structure of the country, freedom itself is being commoditized.

Debtor’s prison are making a comeback because of the debt collection industry. Elites like former Comptroller David Walker are waxing nostalgically for more punitive measures in the face of a population that simply cannot pay its debts. The for-profit prison industry fits right in to this trend, both in terms of the financialization of the industry itself and the increased market for “beds” sought by for-profit prison lobbyists in terms of harsher prison sentences.

Trying to end the war on drugs and stopping the incarceration of undocumented workers should move up the priority list. Once it becomes profitable to put people into steel cages, then it becomes profitable for judges to sell children in some creepy bizarro 21st century version of Oliver Twist. And if you think the housing bubble was bad because it misallocated resources, or foreclosure fraud is bad because it allows powerful actors to seize property based on raw power, then imagine what could happen if the logic of the for-profit prison system met the same type of leveraged financial hurricane.

Excerpt: "Praise to God … who chose a martyr from my family, bestowing upon us the gift of martyrdom, and including us in the community of the Holy Martyrs' families." Thus Sayyed Hassan celebrated the killing by Israel of his eldest son Hadi in combat in September 1997.

In that same speech, Nasrallah expressed relief at Hadi's martyrdom for putting him and his family on equal with all other parents who lost their sons in the fight against Israel.

This is a story worth recounting, for two reasons. Firstly, Sayyed Nasrallah strikes a chord with his Arab constituency for having always acted, thought, and spoken as one of them. He knew poverty; he saw action in the battlefield; and he consistently commits himself to the ideals he has preached.

The other reason, and specifically in relation to the cast of leadership Arab revolution is sweeping away, Nasrallah stands out: the privileges accrued by Arab leaders, their families, sons and daughters - from Libya to Syria - are never tolerated by Hezbollah.

Hadi Nasrallah was neither a Saif Gaddafi nor a Gamal Mubarak; and Nasrallah's cousin, Hashim Safi Al-Din, assigned to the command of the Southern Lebanon region since November 2010, is no Rami Makhlouf, Syria's corrupt billionaire.

'Oracle of the oppressed'

For me two leitmotifs explain Hezbollah: "deprivation" and "resistance". They go hand in hand. They set people like Ragheb Harb, and before him Musa Al-Sadr, who engineered Shia empowerment, on a fascinating course of political history: resistance within against "deprivation" or hirman, and against occupation.

Hezbollah's 1985 first political manifesto, The Open Letter, ["al-Risalah al-Maftuhah"], resonates with Che-Khomeini rhetoric: the language of "world imperialism" mixed with meaning about "the oppressed", "down-trodden", "justice", "self-determination" and "liberty".

The sea of people I saw in August 2006 that came to greet and listen to Nasrallah after the 34-day war with Israel related to these messages. They still do. Many more do the same from Rabat to Sana'a.....

Inspired by Imam Khomeini, Nasrallah modernised Hezbollah and articulated a political project, which embodied empowerment, transforming Ashura and the entirety of the Karabala imaginary into a potent inventory for re-inventing not only the political, but also Shia identity in Lebanon.

Hezbollah and Syria's Revolution

Heralded by millions of Muslim fans as "the mastermind of the resistance" - or "the Muslim Che Guevara" - while demonised by the US Congress and Israel as a "terrorist", Nasrallah's rhetoric vis-à-vis the Syrian regime makes him an oddity in two ways.

Firstly, resistance is not divisible. Resistance is resistance, whether deployed against a colonial oppressor or against the indigenous oppressor, occupying, in this instance, the Arab state.

The same goes for freedom; it is not divisible. Resistance in the quest for freedom applies to the occupied Lebanese and Palestinian as much as to the oppressed Syrian or Yemeni.

Nasrallah was among the first to lend support to Arab revolutions in Egypt and Tunisia, and later to the down-trodden protesting against marginalisation in Bahrain. Withholding support for the uprising in Syria - because the regime supports muqawamah and opposes imperialism - is speaking with two tongues vis-à-vis Arab revolution.

“RETURN-FREE RISK.” That’s just one of the turns of phrase that Jim Grant has tossed off over the years as editor of the invaluable Grant’s Interest Observer and as Barron’s most illustrious alum.

The term could well apply to major money-market funds, which provide yields barely visible to the naked eye but could suffer collateral damage from any potential fallout from a possible default by Greece. Grant was way out ahead of the crowd by pointing out in his latest issue, dated June 17, that the five largest money funds, Fidelity Cash Reserves (FDRXX), Vanguard Reserve Prime (VMRXX), Fidelity Institutional Money Market Market Portfolio (FNSXX), Fidelity Institutional Prime Money Market Portfolio (FIPXX) and BlackRock Liquidity TempFund (TMPXX) held an average of 41% of their assets in European banks’ short-term debt. Fitch Ratings added in a report last week that the top 10 money funds, with assets of $755 billion, had about half their assets in European bank liabilities.

It’s doubtful that any money-fund holder has forgotten the aftermath of the Lehman Brothers bankruptcy in 2008, which caused The Reserve Fund, a pioneer in the field, to “break the buck” — have its net-asset value fall below $1 a share — owing to its holding of Lehman commercial paper. Since the crisis, the Securities and Exchange Commission has mandated money funds hold at least 10% of their assets in paper that can be converted into cash in one day and 30% in paper due in 60 days or less (or redeemable within seven days).

European Central Bank President Jean-Claude Trichet last week declared the financial risk situation was “code red.” That was his characterization of an assessment by Europe’s new risk monitor, the European Systemic Risk Board, that the highly interconnected financial system inside and outside the European Union means debt woes of several countries could spread rapidly if conditions worsen, the Associated Press reported.

Given that, money funds with European exposure and yielding about 0.01% would seem the very embodiment of return-free risk. But it seems the generals have prepared well for the last war, so 2008-style runs aren’t likely.

Excerpt: Mr Bernanke does not need lessons about the painful deleveraging that follows crises. His pioneering work with Mark Gertler on the Great Depression introduced the “financial accelerator”, the mechanism by which collapsing net worth crushes the real economy. This concept has been rechristened the “balance sheet recession” by Richard Koo. Stephen Gordon admits he is new to the term and notes (with some nice charts contrasting America with Canada) “it’s not pretty”. (HT to Mark Thoma). Yet until now Mr Bernanke seemed to think America had learned enough from both the 1930s and Japan to avoid either experience. Reminded by a reporter for Yomiuri Shimbun that he used to castigate Japan for its lost decade, Mr Bernanke ruefully replied, “I'm a little bit more sympathetic to central bankers now than I was 10 years ago”.

He did, however, make the important point that he stands by his view of a decade ago that the Bank of Japan then, and the Fed now, could, if it wanted, prevent deflation, both through the direct effect of monetary policy and its impact on expectations....

Mr Koo has argued that quantitative easing cannot help in a balance sheet recession; only fiscal policy can. Does Mr Bernanke secretly agree? He may believe as strongly as he did a decade ago that sufficiently aggressive monetary policy can prevent deflation, but not that it can create enough demand to restore full employment. This does not rule out QE3; it only means it will be pursued with less hope about the results than a year ago.

Excerpt: The U.S. occupies a special place in global finance. The symbiotic relationship between the U.S. dollar as a reserve currency and the U.S. Treasury market’s monopolistic position as the safest, most liquid bond market in the world has served this country well. This unique position has allowed the U.S. to exercise significant authority in the global economy and enhanced its standing as a world power. Even a temporary default would eliminate the safe and liquid nature of the U.S. Treasury market, harming this country’s ability to exercise its power, to the detriment of the U.S. and the global economy.

The main impact on markets would come from sharply reduced liquidity in the U.S. Treasury market, as financial firms’ procedures and systems would be tested by the world’s largest debt market being in default. Given the existing legal contracts, trading agreements, and trading systems with which firms operate, could U.S. Treasurys be held or purchased or used as collateral? The aftermath of the failure of Lehman Brothers should be a reminder that the financial system’s “plumbing” matters. All the legal commitments and limitations in a complex financial system mean a shock from an event that is viewed as inconceivable – such as a U.S. Treasury default – can cause the system to stall. The impact of a U.S. Treasury default could make us nostalgic for the market conditions that existed immediately after the failure of Lehman Brothers.

Excerpt: Conducted by the Office of the Comptroller of the Currency, the survey covered 54 national banks, including the 14 largest banks overseen by the agency, and covered loans representing about 94% of all loans in the national banking system. Underwriting standards easing particularly in commercial products, and most of the highest share of easing was done by large banks, the survey showed.

But don’t get too excited. Tightening continued in areas that most impact the average American consumer thanks to continued economic uncertainty. Loan portfolios that experienced the most tightening in standards over the last year include credit card, home equity, commercial and residential construction and residential real estate loans. “The health of the economy” was a key factor in tightening, according to OCC examiners.....

The report says that the greatest continuing credit risk in banks continues to be real-estate values given that many banks still hold a high volume of these in their portfolios. Banks that are holding a lot of credit-card loans are also experiencing a lot of risk because of the struggling economy and high unemployment rate, the report said.

Even where underwriting standards tightened, banks still tightened standards far less than previous years. Overall, only 7% of banks reported easing retail loan underwriting standards, while 63% said underwriting was unchanged and 30% tightened standards. Yet in the previous three years’ reports, 68%, 83% and 74% of banks respectively reported tightening underwriting for retail products....

Real estate remains problematic across the board. Among commercial products, commercial real estate loans saw some of the most pronounced tightening and these loans remain “a primary concern of examiners, given the current economic environment and some banks’ significant concentrations relative to their capital.” On the residential side, 40% of banks continued to tighten mortgage lending standards, while 52% left them unchanged after several years of tightening.